The June Employment Report and FOMC Minutes Keep Open Fed Tightening Ahead

The June Employment Report has evidence that can be used by both hawks and doves at the Fed.   For hawks, the bounce-back in Payrolls and uptick in the Average Workweek argue for continued good economic growth in Q317.  For doves, the higher Unemployment Rate and soft Average Hourly Earnings argue that weak inflation pressures allow for stronger growth.  Nonetheless, Fed officials appear intent on following through with their plan for raising the funds rate another 25 BPs this year and beginning to roll off maturing securities from the Fed's balance sheet.  This will probably be a major point in Yellen's semi-annual monetary policy testimony next week -- a negative for both stocks and Treasuries.

The June FOMC Minutes focused on the start-date for rolling off maturing securities, with some officials arguing for September while others arguing for a later date.  While there also was discussion on the potential impact of balance sheet reduction on financial markets, it did not seem as if most Fed officials think it will be large.  Indeed, there was discussion why the rate hikes so far have resulted in easier financial market conditions -- a point likely raised by NY Fed President Dudley, who emphasized this relationship in a recent speech (see my blog on March 31).

There are two points worth noting with regard to these two discussions.   First, Fed officials are emphasizing the "flow" perspective on Fed balance sheet reduction, arguing that a modest quarterly pace would have little impact on financial markets.  However, when Fed staff analyzed the likely impact of Quantitative Easing several years ago, it concluded that the "stock" effect of the announcement was more important than the flow effect of the pace of long-term asset purchases.  In other words, announcing a $120 Bn amount of purchases over a year had a larger impact on financial markets than the $10 Bn monthly purchase.  If this conclusion is correct, the risk is that the announcement of $2Tn reduction in the Fed's balance sheet over the next several years may very well be a large negative for the markets, even though the pace is modest.

Second, Fed officials' puzzlement over the easing of financial market conditions after their rate hikes shows that they do not view the markets from an "optimal control" perspective as I do (see my blog on May 29).   (From this perspective, markets move in ways to achieve the Fed's targets, which means they would work to offset the restrictive impact of the higher funds rate since the Fed did not want to slow the economy.)  As a result, officials may interpret the easier conditions to mean the Fed can tighten more aggressively.   However, the June minutes highlighted a discussion that changes the Fed's objectives.  There was "concern that subdued market volatility, coupled with a low equity premium, could lead to a buildup of risks to financial stability."  This objective -- to prevent a buildup of risks for financial stability -- works against market actions to offset the restrictiveness of a tightening at the short end of the Treasury market.   In particular, the new objective is a problem for the stock market, since it means the economy is more likely to feel the negative effects of the Fed tightening.